Gold and crude oil have been in a slow motion free fall of late, even as U.S. equities rally but ConvergEx's Nick Colas looks at the value of each asset class relative to the other two and assess their historical relationship. For example, you currently need 1.72 ounces of gold at $1178 to “Buy” one S&P 500 index at 2032. That is cheap to the 30-year average of a 1.86x ratio, putting fair value on U.S. stocks 8% higher. Separately, it currently takes 25.1 barrels of crude to buy the S&P 500, versus the 30-year average of 27.8, making stocks look cheap by 11%. Closing out this analytical triangle: you need 14.5 barrels of oil to buy an ounce of gold, but the 30-year average is 16.6. Bottom line using these long-term ranges: U.S. stocks look mildly cheap to oil and gold, but drops in those commodities would erase the difference just as easily as a further rally in stocks. Gold looks cheap relative to oil and should be $170 higher, or oil should trade closer to $71.
Via ConvergEx's Nick Colas,
Would you rather have an ounce of gold or 611 gallons of crude oil? Both cost the same amount as of Friday’s close: $1178. The former has an unrivaled long-term track record of holding value; every ounce of gold ever mined is still worth that not-insignificant $1178. Everyone from gun-toting preppers to the world’s central banks to blingy Rolex-wearing global oligarchs agree it is a good asset to own. On the other hand, the oil – once handed over to your friendly neighborhood refiner – will yield 275 gallons of gasoline plus other hydrocarbon products. That’s enough gas for the average American to drive 6,875 miles, or almost 6 months of daily transportation.
Now, lets throw financial assets into this “Who’d you rather?” style analysis – would you prefer one share of the S&P 500 or an equivalent amount in gold or crude oil? The hard numbers for the non-financial assets are: 1.72 ounces of gold (at that spot price of $1178) or 25.1 barrels of crude (average of Brent and WTI at $81). Aside from revealing any inherent biases you might have related to these options, there are several purposes to such an analysis:
Investors constantly make choices between different asset classes based in part on relative value. Since capital flows freely through the world’s financial and hard asset markets, the price of gold, oil and stocks should maintain some harmony over the long term. Yes, gold haters might say it has no cash flow and peak-oil theorists might posit that crude is structurally underpriced. Markets, however, are more agnostic and often revert to some long-run mean valuation for commodities and financial assets alike.
To determine where gold, oil and stocks might be in some form of long-run equilibrium, you need to assess the price of each through several economic cycles. We pulled the data for the S&P 500, gold prices (courtesy of the Bundesbank) and oil prices (World Bank data, using Brent, West Texas, Dubai and other markets). There are several charts showing the 6 permutations of gold/oil/stocks in ratio form immediately after this note, all going back to 1970. Oil back then, by the way, was less than $2/barrel. Good times…
The recent volatility in gold and oil markets, while U.S. stocks chug higher, first sparked our interest in this topic. Such sharp moves are usually more about sentiment shifts than long-run fundamentals. A multi-cycle analysis usually washes out the vagaries of investment fashions and reveals truer – and more sustainable – valuation parameters.
So what does the record show on the question of relative fair value in the case of gold, oil and silver? Here are our findings:
U.S. stocks look slightly cheap on long run measures versus both gold and oil. Here’s the math:
Over the last 30 years, stocks have traded at an average 27.8 multiple to global crude oil prices based on monthly closing prices for each. With the S&P 500 at 2032 and Brent/WTI at an average price of $81, that is a ratio of 25.1 now. If we were right on the long-run averages, the S&P 500 would sell for 2252, or 11% higher than current levels. Of course, oil could drop further to resolve this imbalance, in which case a per barrel price of $73 would bring it back into balance with the S&P at current levels.
Both assets have, of course, seen their own bubbles in the last 30 years. Crude got to $140/barrel in 2008, and the S&P 500 saw 1500 in 2000 when oil was just $27.50. Outliers abound in this data series. The 10-year average is 17.1 barrels of crude for every S&P 500 unit, and the 20-year average is 32.5, putting a wide range around any volatility-adjusted mean. That’s a long way of saying that markets can remain out of kilter for a long time and you have to use this kind of assessment very carefully.
As for gold, you’ve needed 1.86 ounces to buy an S&P 500 unit on average over the last 30 years. The current ratio is 1.72, meaning that the S&P 500 has a long-term fair value of 2191,or 8% higher than current levels using the three-decade average ratio. Or, if gold continues to decline, it would have to settle at $1092/ounce to reach long term equilibrium.
As with oil, there has been significant price volatility in gold over the last 30 years. This time horizon does not cover its run to $850 in 1980, but it does encompass the move from below $300 as recently as 2002 to +$1700 in 2012. The 10-year average for the S&P 500 in gold terms is 1.5x and the 20-year average is 2.35x.
We can also use these ratios to assess gold and oil relative to each other. Two point here:
It currently takes 14.5 barrels of crude to buy an ounce of gold. The 30-year average is 16.6, making gold currently look cheap to oil. To bring the two commodities into long-term balance, gold would have to rise 14% to $1345 or oil would need to decline to $71. Or, of course, some combinations of such moves to bring the ratio back to 16.6 times.
Unlike our prior evaluations of U.S. stocks relative to gold and oil, the ratio of these two commodities has been in structural decline for the last 10 and 20 years. Over the last decade, it is 12.6 barrels of crude for every ounce of oil. In the last two decades, the ratio is 14.3.
One final note before reaching a few conclusions. We’ve focused on the 30-year track records – 1984 to 2014 – because this span encompasses several broadly comparable business cycles. Our charts show the data back to 1970, which predates America’s move away from a gold standard in 1971 and captures the oil shocks of 1973 and 1979 as well as the entire 1970s lost decade for stocks. In case you are curious, here are the averages all the way back to 1970:
S&P 500/Gold: 1.53x (1970-present). The current ratio of 1.72 means U.S. equities are overvalued by that measure and the S&P 500 should trade for 1802. That is 11% lower than current levels.
S&P 500/Crude oil: 25.2x (1970-present). We are at 25.1x, so domestic stocks by this count are pretty much exactly where they should be.
Gold/Crude: 17.0x (1970-present). At current prices the ratio is 14.5, gold is cheap and/or oil is expensive. Equilibrium prices would be: gold at $1377 or oil at $69.
The bottom line here is that the drop in crude and gold paired with a continued rally in U.S. equities isn’t as strange as it seems. Looking at the historical record, something had to give to bring prices back into line. As with any change in market sentiment, there are many explanations but few quantifiable facts to help us understand these shifts. The historical relationships between these three asset classes help to fill the void.

